Financing Enterprises (Custom Edition) - (Chapter 12 Money Banks and Interest Rates)
Financing Enterprises (Custom Edition) - (Chapter 12 Money Banks and Interest Rates)
Financing Enterprises (Custom Edition) - (Chapter 12 Money Banks and Interest Rates)
INTRODUCTION
In this chapter we are going to look at the important role that the banking system plays in
the economy. Changes in the behaviour of financial institutions and in the supply of money
can have a powerful effect on all the major macroeconomic indicators, such as inflation,
unemployment, economic growth, exchange rates and the balance of payments.
But why do changes in the money supply affect the economy? Well, the supply of
money and the demand for money between them determine the rate of interest, and this
has a crucial impact on aggregate demand and the performance of the economy generally.
But, more than this, many aspects of economic activity are dependent on the availability of
money.
The very first question addressed in this chapter is to define what is actually meant by
money (not as easy as it may seem) and to examine its functions. Then in Sections 12.2 and
12.3 we look at the operation of the financial sector of the economy and its role in determin-
ing the supply of money. This sector has come in for considerable scrutiny in recent times,
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following the banking turmoil associated with the ‘credit crunch’ of 2007–09.
We then turn to look at the demand for money. Here we are not asking how much
money people would like. The answer to that would probably be ‘as much as possible’! What
we are asking is: how much of people’s assets do they want to hold in the form of money?
Then, in Section 12.5, we put supply and demand together to show how interest rates
are determined, or how money supply must be manipulated to achieve a chosen rate of
interest. We will see how changes in money supply and/or interest rates affect aggregate
demand and the level of activity in the economy.
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People can access and use the money in their accounts through B-pay, cheques,
debit cards and so on without using cash. Only a very small proportion of these deposits,
therefore, needs to be kept by banks in the form of cash.
What items should be included in the definition of money? To answer this we need to
identify the functions of money.
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BANKS
Four banks—Australia and New Zealand Banking Group Ltd, Commonwealth Bank,
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National Australia Bank and Westpac—account for around 74% of all bank assets.
Banks accept deposits and, as explained in Section 12.3, by making loans they create
credit. They offer a wide range of retail banking services and operate, with the Reserve Bank
of Australia, the payment system through which the banks’ debts with each other are settled
daily. Banks are also heavily involved in dealing, both on their own account and on behalf
of their customers, in the foreign exchange market.
Assets and liabilities
Liabilities. Most of the banks’ liabilities take the form of the accounts, or deposits, held
with banks by individuals, companies, universities and so on. There are three major types
of deposit. First, demand deposits—any deposits that can be withdrawn on demand by the
depositor without penalty. In the past, demand deposits did not pay any interest but aggres-
sive competition between banks has led to a number of interest-paying demand deposits.
Second, time deposits, which require notice of withdrawal. They pay a higher rate of inter-
est than demand deposits. The third type of bank deposit is Certificates of Deposit (CDs).
These are certificates issued by the banks to companies and other financial institutions for
large deposits of a fixed term (e.g. $1 million for three months). They can be sold from one
customer to another and hence they are relatively liquid to the depositor. The use of CDs
hasPearson
Titman, Sheridan, et al. Financing Enterprises (Custom Edition), grown rapidly
Education in recent
Australia, years.
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Assets. The banks hold a small proportion of their assets in currency and hold deposits
with the Reserve Bank in the same way that the public holds deposits with the banks. The
great majority of the banks’ assets comprise loans to customers. These vary in liquidity
depending on whether they are short-term overdrafts, two- or three-year personal loans,
business loans, loans made in the form of 25-year mortgages and so on.
Liquidity and profitability
The balance between the various forms of liability and assets is influenced by three consid-
erations: profitability, liquidity and capital adequacy.
Profitability. Profits are made by lending out money at a higher rate than that paid to
depositors. The average interest rate received by banks on their assets is higher than that
paid by them.
Liquidity. The liquidity of an asset is the ease with which it can be converted into cash liquidity The ease by which an
without loss. Cash itself, by definition, is perfectly liquid. asset can be converted into cash
The notes and coins inside a bank plus a bank’s deposit account at the Reserve Bank are without loss.
called bank reserves. Bank reserves are highly liquid and can be lent on an overnight basis bank reserves The notes and coins
to other banks and financial institutions. Other assets are much less liquid. Loans to the inside a bank plus a bank’s deposit
general public or home loans can be redeemed by the banks only as each instalment is paid. account at the Reserve Bank.
Banks must always be able to meet the demands of their customers for withdrawals
of money. To do this, they must hold sufficient reserves or other assets that can be readily
turned into cash. In other words, banks must maintain sufficient liquidity.
The ratio of an institution’s liquid assets to total assets is known as its liquidity liquidity ratio The proportion of
ratio. For example, if a bank had $100 million of assets, of which $10 million were liquid a bank’s total assets held in liquid
and $90 million were illiquid, the bank would have a 10% liquidity ratio. If a financial form.
institution’s liquidity ratio is too high, it will make too little profit. If the ratio is too low,
there will be the risk that customers’ demands may not be able to be met: this would cause
a crisis of confidence and possible closure. Institutions thus have to make a judgment as to
what liquidity ratio is best—one that is neither too high nor too low.
Capital adequacy. Banks must have sufficient capital (i.e. funds) to cover losses if borrowers
default on payment. Capital adequacy is a measure of a bank’s capital relative to its assets,
where the assets are weighted according to the degree of risk. The more risky the assets, the
greater the amount of capital that will be required.
Building societies and credit unions. These raise funds mainly from the household sector
and, in turn, lend to the household sector.
Money market corporations. These are also known as merchant banks. They borrow from
and lend to companies in large units of money.
Finance companies. These raise funds from retail investors and in what is termed the
wholesale market. They lend to households and to small businesses.
Securitisers. These pool a range of assets (e.g. housing loans) and sell them to other financial
institutions.
Insurance companies. These companies raise funds from premiums and hold a range of
assets issued by other financial institutions.
Superannuation funds. These manage contributions from employers and employees. They
invest in a range of financial assets.
Refer to Chapter 8 for more details about non-bank financial intermediaries.
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operate its monetary policy in a way that will best achieve the following objectives:
• the stability of the currency of Australia
• the maintenance of full employment in Australia
• the economic prosperity and welfare of the people of Australia.
In recent years the view has emerged in official circles that the best way of achieving
PAUSE FOR THOUGHT these objectives is to maintain some degree of stability in the price level. In 1996 an exchange
of letters occurred between the Treasurer and the Governor of the Reserve Bank. It was
Will the Reserve Bank’s
monetary policy objectives
agreed that the Reserve Bank would operate monetary policy with the aim of keeping the
conflict with each other at inflation rate, over the economic cycle, in the range of 2–3%. The objectives and operation
times? of monetary policy are described in more detail in Chapter 13.
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4. Banks raise their money mainly by accepting deposits. There are three types of
deposits: demand deposits, time deposits and Certificates of Deposit.
5. Banks aim to make profits but they must also maintain sufficient liquidity. The
liquidity of an asset is the ease by which it can be turned into cash, without loss.
Liquid assets, however, tend to be unprofitable and profitable assets tend to be
illiquid. Banks therefore hold a range of assets of varying degrees of profitability
and liquidity.
6. Banks have to make decisions about how many assets to hold in liquid form.
The liquidity ratio of a bank measures its proportion of assets held in liquid form.
7. Banks are required to have a capital adequacy ratio (CAR) of at least 8%. A bank’s
CAR is the ratio of shareholders’ capital plus reserves to its risk-weighted assets.
8. The Reserve Bank of Australia is the central bank. It issues notes, acts as a banker
to the government and to banks, holds the official reserves of foreign currency and
is responsible for monetary policy.
different types of account have become blurred and it is increasingly easy to switch deposits broad money Cash in circulation
from one type of account to another. For these reasons, the most usual measure that plus bank deposits plus net
countries use for money supply is broad money, which in most cases includes all bank borrowings from the private sector
deposits and the liabilities (deposits) of NBFIs. by NBFIs.
$ billion
Currency 61.3
Equals M1 318.7
Equals M3 1746.3
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As we have seen, bank deposits in one form or another constitute by far the largest
component of (broad) money supply. To understand how the money supply expands and
contracts, and how it can be controlled, it is necessary to understand what determines
the size of bank deposits. Banks can themselves expand the amount of bank deposits and,
hence, the money supply by a process known as ‘credit creation’.
Loans 90
Now assume that the government spends more money—$10 billion, say, on roads or
education. It pays for this with cheques drawn on its account with the central bank. The
people receiving the cheques deposit them in their banks. Banks return these cheques to
the central bank and their balances correspondingly increase by $10 billion. The combined
banks’ resulting balance sheet is shown in Table 12.4.
But this is not the end of the story. Banks now have surplus liquidity. With their
balances in the central bank having increased to $20 billion, they now have a liquidity ratio
of 20/110. If they are to return to a 10% liquidity ratio, they need only retain $11 billion as
balances at the central bank ($11 billion/$110 billion = 10%). The remaining $9 billion they
can lend to customers.
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Assume now that customers spend this $9 billion in shops and the shopkeepers deposit
the cheques in their bank accounts. When the cheques are cleared, the balances in the central
bank of the customers’ banks will duly be debited by $9 billion, but the balances in the
central bank of the shopkeepers’ banks will be credited by $9 billion: leaving overall balances
in the central bank unaltered. There is still a surplus of $9 billion over what is required to
maintain the 10% liquidity ratio. The new deposits of $9 billion in the shopkeepers’ banks,
backed by balances in the central bank, can thus be used as the basis for further loans. A
total of 10% (i.e. $0.9 billion) must be kept back in the central bank, but the remaining
Loans 90
Total 110 Total 110
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90% (i.e. $8.1 billion) can be lent out again. When the money is spent and the cheques are
cleared, this $8.1 billion will still remain as surplus balances in the central bank and can
therefore be used as the basis for yet more loans. Again, 10% must be retained and the
remaining 90% can be lent out. This process goes on and on until eventually the position is
as shown in Table 12.5.
The initial increase in balances with the central bank of $10 billion has allowed banks
to create new advances (and hence deposits) of $90 billion, making a total increase in
monetary supply of $100 billion.
This effect is known as the bank multiplier. In this simple example, with a liquidity bank multiplier The number
ratio of 1⁄10 (i.e. 10%), the deposits multiplier is 10. An initial increase in deposits of of times greater the expansion
$10 billion allowed total deposits to rise by $100 billion. In this simple world, therefore, the of bank deposits is than the
bank multiplier is the inverse of the liquidity ratio (L). additional liquidity in banks that
causes it: the multiplier is the
Bank multiplier = 1⁄L inverse of the liquidity ratio.
In practice, the creation of credit is not as simple as this. There are three main
complications. PAUSE FOR THOUGHT
Loans 90
Total 200 Total 200
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Ms Ms
Rate of interest
Rate of interest
base for increasing loans. When the loans are redeposited in banks, they form the base for yet more loans and, thus,
a process of multiple credit expansion takes place. The ratio of the increase of money to an expansion of the liquidity
base is called the ‘bank multiplier’. It is the inverse of the liquidity ratio.
11. In practice, it is difficult to predict the precise amount by which money supply will expand if there is an increase in
banks’ liquidity. The reasons are that banks may choose to hold a different liquidity ratio; customers may not take up
all of the credit on offer; there may be no simple liquidity ratio, given the range of near money assets; and some of the
extra cash may leak away into extra cash holdings by the general public.
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Speculation about future returns on assets. The assets motive for holding money depends
on people’s expectations. If they believe that share prices are about to fall on the stock
market, they will sell shares and hold larger balances of money in the meantime. The assets
demand, therefore, can be quite high when the price of securities is considered certain to
fall. Some clever (or lucky) individuals anticipated the 2008–09 stock market decline. They
sold shares and ‘went liquid’.
Generally, the more risky such alternatives to money become, the more people will PAUSE FOR THOUGHT
want to hold their assets as money balances in a bank or credit union.
People also speculate about changes in the exchange rate. If businesses believe that Which way is the demand
the exchange rate is about to appreciate (rise), they will hold greater balances of domestic for money curve likely
currency in the meantime, hoping to buy foreign currencies with them when the rate has to shift in each of the
risen (since they will then get more foreign currency for their money). following cases? (a) Prices
rise, but real incomes
The rate of interest. In terms of the operation of money markets, this is the most important stay the same. (b) Interest
determinant. It is related to the opportunity cost of holding money. The opportunity cost rates abroad rise relative
is the interest forgone by not holding higher interest-bearing assets, such as shares, bills or to domestic interest rates.
bonds. Generally, if rates of interest rise, they will rise more on shares, bills and bonds than (c) People anticipate that
on bank accounts. The demand for money will fall. The demand for money is thus inversely share prices are likely to
fall in the near future.
related to the rate of interest.
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Rate of interest
MD
0 Quantity of money
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Ms
Rate of interest
re
MD
0 Me
Quantity of money
As the rate of interest falls, there will be an increase in the demand for money, especially
asset balances (a movement down along the demand for money curve). The interest rate
will go on falling until it reaches re. Equilibrium is then achieved.
Similarly, if the rate of interest is below re, people will have insufficient money balances.
They will sell securities, thus lowering their prices and raising the rate of interest until it
reaches re.
A shift in either the Ms or the MD curve will lead to a new equilibrium quantity of
money and rate of interest at the new intersection of the curves. For example, an increase
in the supply of money will cause the rate of interest to fall, whereas a fall in the supply of
money will cause the rate of interest to rise.
Figure 12.4 shows the effect of a decrease in the supply of money. To start with, the
demand for money is given by MD0 and the supply of money by MS0 and the equilibrium interest rate
is r0. Now the Reserve Bank wants to raise the interest rate to r1. It cannot simply dictate this. With
an unchanged money supply at this higher interest rate there would be an excess supply of money, b
– a. So, at the same time as it increases the interest rate, it decreases the money supply and the money
supply curve shifts to the left, to MS1.
MS1 MS0
Rate of interest
r1 a b
r0
MD0
0
Quantity of money
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• A rise in money supply will lead to a fall in the rate of interest: this is necessary to
restore equilibrium in the money market.
• The fall in the rate of interest will lead to a rise in investment and other forms of
expenditure, such as on consumer durable goods and housing, which is financed by
borrowing.
• The rise in investment and consumption will mean increased injections into the circu-
lar flow of income. The effect will be a rise in aggregate demand, a resulting rise in GDP
and possibly a rise in inflation too.
• These effects will be reinforced by international effects. The fall in the interest rate is
likely to cause the exchange rate to depreciate, as the return on Australian financial
assets will now be reduced relative to those offered by overseas financial assets. This
depreciation will increase exports and decrease imports.
KEY TERMS
bank multiplier 321 liquidity ratio 317
bank reserves 317 medium of exchange 315
broad money 319 monetary base 319
financial intermediaries 316 money multiplier 321
liquidity 317
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STUDY QUESTIONS
12-1. How successful in the last year has the Reserve Bank been (c) an increased use of credit cards.
in achieving its objectives? 12-6. What effects will the following have on the equilibrium
12-2. Why might the relationship between the demand for rate of interest? (Consider which way the demand and/or
money and the interest rate be an unstable one? supply curves of money shift.)
12-3. Imagine you earned $10 000 a month and spent it evenly (a) Banks find that they have a higher liquidity ratio than
over the month. What would be your average cash bal- they need.
ance? If the interest rate was 20% per year, how might you (b) There is a rise in incomes.
reduce your average cash holding while still spending all (c) There is a growing belief that interest rates will rise
your income? from their current level.
12-4. Why do banks hold a range of assets of varying degrees of 12-7. Trace through the effect of a fall in the supply of money
liquidity and profitability? on aggregate demand. What will determine the size of the
12-5. What effect would the following have upon the demand for effect?
money curve? 12-8. List the various interest rates charged by your bank or credit
(a) an increasing use of automatic teller machines. union. How would you explain the different interest rates?
(b) an increase in interest rates.
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MULTIPLE-CHOICE QUESTIONS
1. A medium of exchange is: ❏❏ (c) How much cash do you wish you could have?
❏❏ (a) a standard unit that provides a consistent way of ❏❏ (d) What proportion of your financial assets do you
quoting prices. want to hold in non-interest-bearing forms?
❏❏ (b) what sellers generally accept and buyers generally 5. Banks can create money:
use to pay for goods and services. ❏❏ (a) by offering financial services, such as money
❏❏ (c) an asset that can be used to transport purchasing market accounts.
power from one period of time to another. ❏❏ (b) by printing additional currency notes.
❏❏ the ability to buy something today but defer pay-
(d) ❏❏ (c) by paying interest to their depositors.
ment to the future. ❏❏ (d) by making loans that result in additional deposits.
2. John received an income tax refund of $500 in August 6. If real GDP falls:
2012. He put the money in a drawer and spent it when he ❏❏ (a) the quantity of money demanded will fall.
went on holiday to Bali in July 2013. This is an example of ❏❏ (b) the interest rate will rise.
money serving as: ❏❏ (c) the demand for money curve will shift to the left.
❏❏ (a) an investment good. ❏❏ (d) none of the above will necessarily happen.
❏❏ (b) a store of value. 7. The quantity of money demanded increases as the interest
❏❏ (c) a unit of account. rate falls, because:
❏❏ (d) a medium of exchange. ❏❏ (a) people need more money for transactions.
3. Which of the following would shift the demand for money ❏❏ (b) the opportunity cost of holding money falls.
curve to the left? ❏❏ (c) people demand more financial assets.
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❏❏ (a) a rise in interest rates. ❏❏ (d) the exchange rate will rise.
❏❏ (b) a rise in real GDP. 8. If the interest rate increases:
❏❏ (c) a decrease in the price level. ❏❏ (a) the demand for money curve will shift to the left.
❏❏ (d) a decrease in the money supply. ❏❏ (b) the supply of money curve will shift to the left.
4. When economists speak of the ‘demand for money’, which ❏❏ (c) the transactions motive will lead to people holding
of the following questions are they asking? more money.
❏❏ (a) How much income would you like to earn? ❏❏ (d) none of the above.
❏❏ (b) How much wealth would you like?
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